Bonds still remain a great bet despite Dow record

The Sterling Report

At the start of 2014, great concern loomed over the prospects of US interest rates rising by mid-year and the possibility of an accelerated Fed taper to further fuel a hike in bond yields. This was also hot on the heels of a massive exodus of cash from emerging market funds and a stock buying spree by many who believed that the US stock market's bull-run will continue for a few more years. In truth, new highs continue to be hit in the stock market even with higher price earnings ratios in comparison to markets across the pond in Europe. What is remarkable however is that bond yields are now lower than they were at the start of 2014 (2.50 per cent vs 3.03 per cent respectively on the 10-yr US Treasury) and some bond funds like the Sterling USD High Yield Bond fund have done near double digit returns year to date.

There was a great deal of scepticism by many fund managers that bonds would perform poorly in 2014, so much so that they stayed far from any managed bond portfolio. This obviously to their detriment as bond funds continued to outperform expectation and in some cases equities. Another example is the year to date performance of the Dow of 1.5 per cent compared to the Bloomberg USD Emerging Sovereign Bond index and the Bloomberg USD High Yield Corporate Bond Index that returned 8.6 per cent and 5.8 per cent respectively. Interestingly, although the S&P500 and NASDAQ did 6.1 per cent and 5.5 per cent respective, equities is considered a much riskier asset class than bonds and the returns for this asset class ought to be much higher than a bond fund to compensate for the greater risk assumed. In other words, there should be the appropriate risk adjusted return.

Much of this stock euphoria is tied to the view that unemployment is declining, growth is picking up and inflation is rising. The irony here is that the stock market has long been viewed as a barometer of economic activity and portends growth in the economy, however the numbers do not bear out on this measure. The US economy is not yet out of the woods even with more promising greenshoots from employment data and GDP (ignoring the first quarter decline due to weather). However, one has to look behind the numbers to do some assessment of the true picture and whether bonds are still viable.

June's employment data revealed an economy adding 288,000 jobs, more than 70,000 jobs than the market expected. This resulted in a decline in the unemployment rate to 6.1 per cent just shy of a psychological level implanted by Fed officials. In previous minutes, the Fed had indicated that it may be possible for them to consider further reductions in QE3 or even rate hikes once unemployment crashed through the 6 per cent barrier. These numbers sent stock lovers over the edge on a further buying spree resulting in an even higher record for the Dow. The point of caution here is that while the unemployment level is at a near 6-year low, concerns still remain in the types of jobs being created and the level of wages being paid. The number of persons in part-time jobs vis-à-vis full time jobs rose during the period while the numbers of persons who have given up on employment prospects remain at decades long lows. This would suggest there is still sufficient weakness in the economy for a healthy dose of caution.

US inflation, although now approximately 2.1 per cent is still not high enough to shake the Fed into rate hikes anytime soon. The Fed in its recent minutes has expressed some concern about weak wage inflation which is counter to what is needed to drive economic growth. Monetary policy in many of the world's largest economies have been inflation centric as a tool to spur growth, however, lower wage levels on average imply a still weak economy. Given the low wage levels and the preponderance of part time employment, hikes in inflation rates would stymie consumer's purchasing power restricting growth.

So what does this all mean for bonds? My best bet is still a buy. Consensus seems to be gathering around a possible October end to the Fed's bond buying exercise. The Fed's language is still cautious on any possibility of hike in rates and this uncertainty has kept many fund managers also cautious, though they are yet to abandon the bond market. One thing is for certain, those fund managers that took the bet on bonds so far in 2014 have been smiling happily to the bank (as it were) and expect to earn possibly double digit returns on their portfolios by year end. For my two cents worth, if all else fails, at least there are those pesky coupon payments.

Note: The SGF High Yield Bond Fund is not licenced for distribution in Jamaica and neither the author nor Sterling Asset Management is soliciting interest in the fund.

Kevin Richards is vice president, Sales and Marketing at Sterling Asset Management Ltd. Sterling is a licensed securities dealer and provides investment management and advisory services to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, please e-mail us at: info@sterlingasset.net.jm or visit our website at www.sterling.com.jm. Like our page on Facebook and follow us on Twitter.

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